Close
How to Invest in Oil. #Oil #Investing

How to Invest in the Oil Sector

Shares

With the world increasingly turning to electric vehicles and renewables sources of energy, can Oil add any value whatsoever to an investment portfolio? Does it make sense investing in this commodity for the long run? Or only as a short-term “bet”? Or not invest at all?

Crude Oil

This commodity was first discovered and developed during the Industrial Revolution. The machines that enabled the massive increase in work output, were possible due to fossil fuels such as crude oil.

Even as the world economy is massively investing in shifting the sources of energy toward renewables such as wind or solar power, the demand for oil keeps rising. Year after year.

This point is particularly important because many people have argued (for decades now) that we should shift from oil due to:

  • Environmental reasons: A fact that’s indisputable. We should do everything that we can to produce energy without polluting the environment.
  • Scarcity possibility: Here the evidence has shown the opposite. In 1973 the World reserves (billion barrels) were 635. Fast-forward to 2003 and the estimations of World reserves increased to 1148 billion barrels. 882 (77%) were from OPEC, and 266 (23%) were non-OPEC.

Global oil reserves in 2016 were 1707 billion barrels (70% OPEC), which would be sufficient to meet 50.6 years of global production at 2016 levels. (Source: BP)

If reserves were constant, and the demand increased, the price of oil would jump immediately. Law of demand and supply. But that isn’t what we’re seeing. It’s quite the opposite: reserves of oil are increasing, due to technological advances that enable extractions in new places. Therefore and apparently the price of oil has been driven by other reasons (or players…).

Source: IEA

Ways to Invest in Oil

In the modern world, there are several ways an investor could (try to) profit from an increase in the price of this commodity. Here are some examples (for information purposes, not financial advice or any kind of advice).

  • Invest directly in oil. Through an investment in Futures Contract (for delivering oil). Its value goes up if the price of oil goes up. And down if the price decreases. It can be sold before the contract expires. The average uneducated investor shouldn’t invest this way. To much risk and complexity.
  • Individual company. Another risky option, since you can have multiple situations that increase the risk: the price of oil, poor management, geopolitical risk where the company is operating, and so on. Companies in this sector don’t move exactly according to the price of oil, but usually, their profits are superior when the price of oil is high (and inferior when the price of oil is low). Also a risky option… not for the average investor in my opinion.
  • Invest in a mutual fund or an exchange-traded fund of companies. This enables an investor to diversify between players of the oil sector such as refiners, producers or distributors. You have less risk when compared with investing in a single stock or future contract.
  • An ETF of Oil. With this option, the investor knows that the investment will fluctuate with the price of crude oil on a daily basis. It’s an easier way to invest “directly” in oil, although it has some problems such as it rarely matches exactly the price of oil.

Other ways

You have additional options to invest in oil, but normally it’s a variation of the above. For example, if you strongly believe the price of oil is going up, thus the value of the companies of that sector will go up, you have leverage instruments. For example the Direxion Daily S&P Oil & Gas Exp. & Prod. Bull and Bear 3X Shares seeks daily investment results, before fees and expenses, of 300%, or 300% of the inverse, of the performance of the S&P Oil & Gas Exploration & Production Select Industry Index. Of course, it can’t guarantee those results, and again I don’t think it’s appropriate for the average uneducated investor.

How is the Oil price now?

International oil prices surged to almost $75 a barrel this past week and U.S. gasoline is the highest in almost three years, which could have significant effects worldwide. It even took the President of the U.S., Donald Trump to tweet: “Looks like OPEC is at it again, (…) Oil prices are artificially Very High! No good and will not be accepted!”.

Remember when I said earlier in this post that OPEC controls almost 70% of the world reserves? Well in theory that gives them the power to move the price of oil. How? By extracting less, you have less supply. If the demand is growing (as it is…) you will inevitably push the price of oil.

United Arab Emirates Oil Minister Suhail Al Mazrouei denied and said: “There are many things affecting the market, not just supply and demand,” including geopolitics that are beyond OPEC’s control, he said.

Oil Economics

Without any doubt, an organization that controls 70% of the supply of any market, can control to some extent the price of that commodity. The problems with this theory is that:

  • OPEC is not the normal well-disciplined organization. Its members are Republic of Iran, Iraq, Kuwait, Saudi Arabia and Venezuela (founders). And were later joined by Qatar (1961), Indonesia (1962), Libya (1962), the United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Ecuador (1973), Gabon (1975), Angola (2007) and Equatorial Guinea (2017). Indonesia has now left, so in fact, there are only 14 countries. When you have so many countries with different needs and objectives, you can have some breaching the agreement (for pushing the price of oil), therefore selling at a lower price. Especially if they need money for political reasons (public budget or paying debt).
  • Demand does play an important role. Global oil demand growth in the first three months of this year is forecast to reach 2.55 million barrels a day, the strongest year-on-year expansion since 2010. This can really be one of the major factors to push the price of oil.
  • Shale Oil. Another argument is that producing Oil through shale extraction (the process that the U.S. and other countries are using), results in a new alternative to the powerful OPEC. We know that there are different costs of extracting. Some say that Saudi Arabia extracts very efficiently at $10 a barrel. In other countries of OPEC, it could reach $30-$40. Shale oil costs a lot more to produce, but recent technological innovations point to an average cost of $60. If this is true, you can almost “visualize” an invisible barrier in the price of oil, because any increase in price by the OPEC members will face immediate competition from Shale players all over the world.
  • New sources of energy. With new competitive alternatives such as wind and solar power, plus fossil alternatives like natural gas, the competition in the energy sector is higher than before. And these sources will also help to offset any major push in the price of oil.

What Does this Means to the Investment World?

My point with this post is to draw two major conclusions:

  1. News of the death of Oil was (and still is) greatly exaggerated. With news points and technologies for extraction, growing reserves and increasing demand, the argument of scarcity doesn’t hold (for now at least). Therefore this commodity will still be an alternative in the world of energy for the coming decades. Additionally, with emerging countries growing energy needs, I don’t believe that demand will fall to zero in the next years.
  2. More competition, less monopoly. The difference now in comparison with past decades is that oil has been attacked as number 1 alternative in the energy sector. With so many alternatives (including fossil and nuclear), I find it very hard to see oil reaching a high price and stay there for years. The competition will simply (and immediately) push the price down. Even companies such as Exxon, BP or Shell are increasingly investing in other sources of energy. Therefore transforming from old oil producers to new energy producers.

Investing in ETFs – Historical performance

With the sharp increase in oil prices, is tempting to move some money to this commodity. Let’s look at a comparison between the ETF BNO ( United States Brent Oil Fund) and the SPY in the last 12 months.

Obviously, with the increase in the price of oil in the last months, plus a poor performance of the SPY since the beginning of 2018, you can be lead to draw wrong conclusions. First of all look at the volatility of BNO vs SPY: almost double. And then look that the same comparison in the last 36 months.

Source: ETF Replay

Auch! It even hurts just looking at it…

My take is simple:

If you’re an investor, who prefers to invest for the long run, you should focus:

  • On having a diversified basket of stocks and bonds, for example through an ETF;
  • Lowering the costs through low expense ratio funds;
  • Keep it simple (one or two ETFs);
  • Rebalance within a fixed period of time, or when the portfolio becomes too unbalanced.

And guess what?

If I invest my money in the SPY (SPDR S&P 500 Index) or VT (Vanguard FTSE Global All Cap), I will always have a portion of my money invested in the energy sector. Thus indirectly invested in commodities such as oil. Don’t complicate what is simple and easy.

With  Vanguard Total World Stock ETF (VT), you are invested in approximately 8,000 holdings in over 47 countries, including both developed and emerging markets. Expense Ratio of 0.10%.

How much money in Oil & Gas? 5.8%, as of 04/20/2018.

If you’re an investor who really wants to invest directly in oil/companies in the oil sector, then prepare yourself for a lot of volatility, the possibility of having strong competition in the coming years, and the risk that your investment return could be affected by an organization (such as OPEC), country, or even some geopolitical event.

This post is only for information and education purposes. It’s not financial advice or any kind of advice. 

And you reader? What’s your opinion regarding oil? An asset worth investing, or too much risk/volatility for your taste? 

(Take this to Pinterest)

How to Invest in the Oil Sector #Oil #Investing

Shares

About GTRetire

GTRetire is the founder of GrowtoRetire, a blog about financial independence and early retirement. Click here to learn more about starting a blog! Also, this post may contain affiliate links, please read the disclaimer for more info.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.